Don't Fall for the Lottery Syndrome

I learned something interesting the other day. It seems that a study from Carnegie Mellon University has shown that when people are feeling poor -- whether or not they actually are -- they're likely to spend more money on lottery tickets.

We know that lotteries are not the best place for our money. Over the long haul, they eat up about half of what we "invest" in them. So while we'll win some money here and there, if we keep playing, nearly all of us will end up losing a lot.

While truly poor people may see the lottery as the only chance they'll ever have to escape poverty, the Carnegie Mellon study showed that even fairly well-off people are susceptible to lottery temptation. According to the study, those who were made to feel relatively poor bought nearly double the number of tickets as the study's control group. And when participants were told that while "different income groups face unequal outcomes in education, jobs and housing, everyone has equal chances of winning the lottery," they bought tickets at nearly triple their previous rate.

Stock lotteriesThat information rings true for me when I think about stock market investing, too. For example, remember that it's often the less educated among us who devote a higher percent of our dollars to lottery tickets. Similarly, in the investing arena, it's those who are less savvy who make some very basic mistakes, often trying to grab big payouts by taking on high risks.

Think of penny stocks, for instance. Larry might look at others around him and feel unwealthy. He might imagine his neighbors' portfolios full of lots of shares of stock. He may then plunk some money into penny stocks (those trading for less than $5 per share), so that he can feel rich. After all, just $500 spent on a $0.15 stock will get you more than 3,000 shares.

This is a classic error, thinking that a stock is a bargain because it looks "cheap." Remember that a stock price alone doesn't mean much. You have to relate it to something, such as earnings per share (EPS). Divide a current stock price by EPS and you get a P/E ratio, giving you a very rough idea of the stock's attractiveness. (The lower the P/E the more of a bargain the stock may be.) Check out the table below:

You can see here that although Goldman Sachs stock trades for more than 20 times the price of Huntington Bancshares stock, its P/E is actually lower. So just based on the P/E, you'd conclude that Goldman Sachs stock looks cheaper.

Meanwhile, MasterCard's stock price, in the $200s, may look cheaper than Washington Post stock, in the $600s. But the P/E suggests that MasterCard is more overvalued. Of course, P/E alone isn't enough to make a company a good investment. Investors should be asking questions about the various companies' growth rates, competitive advantages, profit margins, etc.

When desperation happensBe careful when you feel any financial desperation creeping into your life. That's the time when you may begin taking on too much risk, when you'll decide to take a chance on some penny stocks that an email has promised will soar in value soon.

You always need to take on risk intelligently. The most exciting investing strategy (to me) that we offer our readers is our Rule Breakers approach. It has served me very well, helping me turn $3,000 into $210,000 and to triple my money in relatively short periods of time. But it's not without risks. It's an aggressive approach. I like to keep it as part of my overall investing, but I don't put all my money in it. With other approaches we recommend, you're likely to find investments that will be less volatile, but will also probably not stand a chance of advancing as quickly as successful Rule Breakers investments. (Try our Rule Breakers newsletter free for 30 days, and you'll be able to see all our recommendations.)

Be a sensible investor: Save and invest regularly. Have realistic expectations. (The stock market has averaged an annual return of around 10% for many decades -- you're more likely to average 8% to 12% than you are 20% to 40%.) Plan to grow wealthy gradually, by investing in strong and growing companies. And if you'd like to take on some extra risk in order to try and earn extra rewards, look into approaches such as Rule Breaker investing.

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